To prevent foreclosures, Fannie and Freddie currently offer principal forbearance to people who owe more on their mortgages than what their homes are now worth.

A borrower who receives principal forbearance can defer payment and interest on a portion of the loan – typically the “underwater” portion – until he sells or refinances his home. Principal forbearance will lower the monthly payments but the borrower will have to repay the entire loan amount eventually.

But as the housing market – and the economy – continues to languish, the Obama administration is pushing the FHFA to permit principal reduction for underwater homeowners. Unlike principal forbearance, a borrower who receives principal reduction won’t have to repay the portion of the loan that has been forgiven.

“At the most basic level, the comparison between the loss mitigation strategies of principal forbearance and principal forgiveness is related to who gets the upside.

“For both principal forbearance and principal forgiveness, if a borrower defaults, enterprises lose the same amount.

“However, if a borrower performs successfully on a modification in a principal forbearance mod, the enterprise retains an upside to the forborne amount. But in a principal forgiveness modification, the borrower retains the upside. And so that’s what this figure tells us here – that the borrower re- defaults after the mod, the losses theirs either way.

“If the borrower defaults sometimes later but there’s been some payment down on principal and house price appreciation, then the investors loss through forbearance could be less than it is through forgiveness.

“But if the borrower is successful as a result of this modification – remains current, stays in the home for a while, house prices recover – there’s an opportunity for the taxpayer to be repaid that entire principal amount if forbearance is used. But in the case of principal forgiveness, the amount that was forgiven upfront remains a loss.”

Reason #2: Fear that unscrupulous homeowners may try to “game” the system

“One factor that needs to be considered is the borrower incentive effects. That means will some percentage of borrowers who today are deeply underwater but current on their mortgage be encouraged to either claim a hardship or actually go delinquent in an attempt to capture the benefits of principal forgiveness.

“This is a particular concern for the enterprises because unlike other mortgage participants that can pick and choose where principal forgiveness makes sense, the enterprises must develop a program to be implemented the same way by more than 1,000 seller-servicers.

“In addition, the enterprises will have to publicly announce this program and borrower awareness of the possibility of receiving a principal reduction modification will be heightened among enterprise borrowers…There is a greater possibility that the borrower incentive effects would take place on an enterprise-wide principal forgiveness program.”

“While not a definitive analysis, if current LTV – loan to value – had a strong effect, we would expect that the more underwater the borrower is, the higher the re-default rate would be. However, Fannie Mae data that we present in this slide shows that performance on modified loan does not vary much at all across the loan to value ratio.

“So as you can see in this chart, looking at the current loan to value ratio, at the time to modification even for those deeply, deeply underwater, the re-performance rates on these loan mods have been about the same.

“So what this tells us is that what matters most here is that the performance on loan modifications seems to be more of a function of the payment change to the borrower rather than the loan to value. And this slide is showing indeed the greater the payment decrease that the borrower gets, the greater the re-performance rate on the modification.”

so demarco is going to allow the housing market to perpetrate the same fraud that inflated the home prices so that they can get back to those inflated prices? IF not then his argument is self defeating and he needs to stop the games and step aside so someone more intelligent and less philosophical can take over and correct the mistakes made under a deregulated market.